Article

Factual Summary: Two LCs containing a red clause were issued and confirmed to effect payment of a contract for the sale of construction panels. The red clause permitted advances prior to shipment. The beneficiary drew under the red clauses but only shipped a small portion of the panels. The beneficiary brought an action against the confirmer, alleging that it had improperly, negligently, and fraudulently honored. The trial court dismissed the complaint for failure to state a cause of action. On appeal, affirmed with a dissent.


Legal Analysis:

1. Subrogation: Noting that prior UCC Article 5 "did not speak clearly to subrogation rights created by a letter of credit," the court looked to case law. While noting the general use of subrogation, it declined to apply this equitable principle to letters of credit, relying upon the prior UCC line of cases relating to post-honor disputes and drawing upon a "primary/ secondary" analogy to guarantee law. The opinion also concluded that subrogation was not available under letter of credit practice or the UCP.

2. Alternative Remedies: In response to the applicant's argument that denial of subrogation rights would deprive it of a remedy in the event of fraud, the opinion noted the existence of alternative remedies against the beneficiary and, theoretically, against the issuer if the documents did not comply.

3. Negligence: The court rejected the applicant's negligence claim because no duty of care existed between the confirmer and the applicant.

4. Fraud: Apparently, the court did not regard the facts in the case as creating an issue of fraud. In its opinion, the court indicated that it was unclear whether the LC banks were bound to pay on a red clause regardless of whether the documents conformed. If they did, the court reasoned that there could be no reliance upon a misrepresentation by the confirmer. If they did not, the applicant had an action directly against the issuer. The court was unwilling to contort the terms of the UCP in order to protect the applicant from the terms of what was obviously a poor bargain. Indeed, the court speculated that the applicant may have been compensated for the additional risk which it assumed.

5. Revised UCC Article 5, Analogy to: Concluding that the Revised Section 5-117 permitted subrogation to the applicant of the issuer's rights against the confirmer, the opinion declined to draw on it by analogy, reasoning that 'if the legislature thought the new law merely clarified existing rules, it would not have limited its effect to letters of credit issued after its effective date.'

Dissent: The dissent relied upon the general Oregon law which is widely supportive of a liberal application of the doctrine of subrogation when equity so demands it. It appears that the dissenting judge regarded the confirmer as the party at fault and so "in equity and good conscience ought to pay." To support this approach, the judge relied upon the Prefatory Note to Revised UCC Article 5 which states "that the new provision merely 'clarifies the subrogation rights of an Issuer who has honored a letter of credit. These rights of subrogation also extend to an applicant who reimburses...."'

Comment:

1. This case illustrates the mystery and problems associated with red clauses. Although they can enable the seller to obtain the wherewithal to produce the goods (their origin was in the Asian fur trade in which the trapper was outfitted by the advance), they are subject to abuse and must be carefully monitored by the buyer/applicant. The court understood the risk and showed no inclination to save the applicant from the risk which it had incurred.

Not surprisingly, the court reveals that it does not understand how the clauses work. Its question is whether the LC banks are required to pay only in compliance with the terms and conditions of the LC. The answer is "yes" but there is a nuance which may not be apparent in the question.

Honor must be in compliance with the red clause and not with other terms of the credit unless expressly so provided. Typically, the clauses are simple and can simply be a statement from the beneficiary that it needs the money to obtain the goods. In this case, it appears that the clause required a statement that the beneficiary would present conforming documents later. Whether the documents presented complied with the red clause was not clear from the opinion.

The best summary of these clauses and practical discussion of how to use them wisely is contained in an article by V. Maulella,Red Clause Letters of Credit, 1994 Annual Survey of Letter of Credit Law& Practice 1.

2. The court declines to apply Revised UCC Section 5-117 by analogy. It does so because it apparently disapproves the application of subrogation to letters of credit. Like all LC issues, subrogation and its applicability is no simple matter.

The court oversimplifies the rule under prior UCC Article 5. Subrogation is not excluded and, indeed, an Official Comment suggests that it is available. The cases considering the issue have introduced into the analysis the distinction between primary and secondary liability in explaining why subrogation is available on dependent guarantees but not on independent undertakings. The fact that an undertaking is independent does not mean that the independence is compromised after payment by seeking reimbursement based on rights outside the LC. If that were the case, an assignment of the applicant's rights against the beneficiary would be unenforceable. The critical distinction is between the rights with regard to the letter of credit and with regard to the underlying transaction.

In this scheme, there would be no subrogation by the applicant to the rights of the issuer against the confirmer for two reasons: 1) the absence of privity between the applicant and the confirmer; and 2) the non availability of indirect rights related to the letter of credit as opposed to the underlying transaction.

Revised UCC Section 5-117(b) appears to change this scheme. It provides that:

An applicant that reimburses an issuer is subrogated to the rights of the issuer against any beneficiary, presenter, or nominated person to the same extent as if the applicant were the secondary obligor of the obligations owed to the issuer and has the rights of subrogation of the issuer to the rights of the beneficiary stated in subsection (a).

This suggests that the applicant can assert the issuer's rights against the confirmer. Of what these rights consist is another matter. Where a confirmer has wrongfully honored a presentation, the issuer must itself examine the documents and, if discrepant, dishonor within the proper time under both the UCP and Revised UCC Article 5. Failure to do so results in preclusion. As a result, in every case where the issuer has obtained reimbursement from the applicant, it will be precluded from seeking recovery from the confirmer. As a result, the effect under the revision is similar to the prior law. Despite the availability of subrogation in general (a result which is generally speaking preferable to alternatives such as a warranty), in effect it is not available as between the applicant and confirmer in ordinary circumstances.

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The views expressed in this Case Summary are those of the Institute of International Banking Law and Practice and not necessarily those of ICC or the other partners in DC-PRO.